RESEARCH REPORTS. AMERICAN INSTITUTE for ECONOMIC RESEARCH. Do Tax Cuts Mean Bigger Deficits? Published by. Great Barrington, Massachusetts 01230

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1 Published by AMERICAN INSTITUTE for ECONOMIC RESEARCH Great Barrington, Massachusetts RESEARCH REPORTS Vol. LXIII No. 16 August 26, 1996 Do Tax Cuts Mean Bigger Deficits? Tax cuts that increase what taxpayers can keep out of additional earnings will be self-financing to some extent; but, as the experience of the 1980s shows, enlarging the tax base is no panacea. The Federal government will continue to face large deficits as long as spending remains out of control. As part of The Dole Plan for Economic Growth presented earlier this month, the Republican presidential candidate is calling for cutting individual income tax rates by 15 percent over the next 3 years. His plan also would cut the maximum tax on capital gains from 28 percent to 14 percent; give every middle-income family a $500 per child tax credit; expand the favorable tax treatment of Individual Retirement Accounts; and repeal the 1993 increase in the percentage of Social Security benefits subject to income tax. These changes are estimated to cost $548 billion in tax revenue over the next 6 years. That is, total Federal receipts from 1997 through 2002 are projected by Dole s economists to be $548 billion lower than they would be if the current tax system were left in place. Dole also promises to balance the Federal budget by 2002 and herein lies the controversy. Critics of the plan maintain that balancing the budget and cutting taxes are conflicting goals. Tax cuts lead to lower revenues and therefore bigger deficits, they say. As evidence they cite the 1980s, when, they claim, President Reagan s tax cuts for the rich caused the Federal deficit to balloon. What Really Happened in the 1980s When the 1980s began there were 14 tax brackets ranging from 14 percent to 70 percent. The income levels bracketing each rate were not indexed each year for price inflation as they are now. Thus, when double-digit price inflation in the late 1970s and early 1980s pushed nominal incomes upward, many taxpayers were thrown into higher tax brackets. As a result of this bracket creep they paid a larger share of their income in taxes, even though their real incomes had not increased and may even have declined. Partly due to this bracket creep, Federal receipts increased markedly in the late 1970s, as a percentage of Gross Domestic Product (GDP) (see chart). As part of his first budget, President Reagan called for reducing marginal tax rates by 10 percent, and in 1981 Congress passed the Economic Recovery Tax Act which included a 25 percent reduction in marginal tax rates for individuals, to be phased in by In addition, the maximum tax rate was reduced to 50 percent from 70 percent, effective in 1982, and income tax brackets were scheduled to be indexed annually for price inflation beginning in The 1986 Tax Reform Act subsequently shrank the number of tax brackets to just two, 15 and 28 percent, and broadened the tax base by eliminating loopholes and special provisions, including the favorable treatment of capital gains. What impact did these changes have on Federal revenue? Total receipts decreased from a peak of 19.7 percent of GDP in fiscal 1981 to 17.4 percent in They increased slightly through 1987 and have since fluctuated in a range of about 18 to 19 percent. Individual income tax 85 receipts, which accounted for nearly half of total receipts in the early 1980s, also peaked in 1981 but decreased even more sharply through 1984, in relation to GDP. They rebounded through 1987 but, in contrast to total receipts, they have trended slightly downward since This decrease was offset by an increase in payroll tax receipts, in relation to GDP, in the 1980s. Overall, the combination of income tax cuts and payroll tax hikes in the 1980s returned the ratio of total receipts to GDP to roughly what it was prior to the bracket creep of the late 1970s. More generally, since World War II Federal receipts have fluctuated in a range of 17 to 19 percent under widely differing tax schedules (with the top individual income tax bracket, for example, ranging from 92 to 28 percent). The problem of the deficit is not attributable to lower revenues, but to outlays that have equaled 20 to 23 percent of GDP since the mid-70s. Reaganomics called for reducing government spending, but the Reagan Administration failed to propose major cuts and the modest cutbacks it did propose were treated as dead on arrival by Congress. Instead, Federal outlays increased to postwar highs in relation to GDP. This increase accounted for the huge deficits of the early 1980s. Deficit Reduction in the 1990s After decreasing again as a percentage of GDP during the late 1980s, outlays increased between 1989 and This increase reflected the recession (which de- Federal Receipts and Outlays as Percentages of GDP (Fiscal year) Outlays Receipts

2 pressed GDP and led to higher outlays for safety net programs) and to the Federal bailout of the savings and loan industry. Spending as a percent of GDP turned downward again in 1992, largely as a result of three factors: the winding down of the thrift bailout (which actually became a source of revenue when the Government sold off the assets of failed thrifts), the improved economy, and sharply lower defense spending. Interest payments on the national debt also increased less than expected, due to lower interest rates, and the growth of spending on some domestic programs slowed. Moreover, Federal receipts have increased in relation to GDP since 1992, reflecting the rebound in economic activity and tax increases that took effect in The combination of lower spending and higher receipts has cut the deficit by half since 1992, in relation to GDP. The deficit in fiscal 1995 was $164 billion, or 2.3 percent of GDP, the lowest ratio since The most important determinant of future deficits will be spending. Defense spending is now at its lowest level in relation to GDP since before World War II, and payment on the debt is not a discretionary item. This leaves domestic programs, including the large and fast-growing entitlement programs. For the next decade or so, the deficit can be contained or even eliminated by modestly slowing the growth of such programs. Financing problems with these programs are expected to worsen rapidly early in the next century, however, when the proportion of the population eligible for age-based entitlements will increase. This demographic trend is expected to result in substantially higher outlays for Social Security, Medicare, and the portion of Medicaid that pays for long-term nursing care. It is difficult to see how overall spending can be contained without substantially changing these programs. If such spending is not curtailed, either taxes will have to increase to a level much more onerous than it already is, or the deficit will increase. It is important to note that this fiscal squeeze could be eased if future economic conditions turn out to be better than currently expected that is, if the economic pie becomes so much larger that the slice needed to pay for promised entitlements and other outlays does not become much bigger than it is now. One of the stated objectives of the Dole tax cut plan, in fact, is to increase the real rate of economic growth to 3.5 percent or higher. This is a lot more optimistic than the average 2.5 percent growth rate that GDP experienced from 1969 to 1995, and that most economists incorporate into their long-term forecasts. The only ways to achieve such growth are to substantially increase the amount of labor that goes into producing goods and services (by increasing the percentage of the population that works, say) or to increase productivity. In this respect, changes in the tax code could make a difference. Incentives for Sound Growth Some proposed tax cuts would have a bigger impact than others on incentives to work, save, and invest. For example, the proposed $500 tax credit per child for middle and lower income families would lower these families total tax bill and leave them with more money to spend. It also would be worth more to lower bracket families because it would reduce their tax bills by a larger percentage. However, it would not affect the marginal tax that a family pays on each additional dollar of income. Because it would not increase the financial reward from obtaining an extra dollar of income, its effect on the incentive to obtain (and report) income probably would be minimal. On the other hand, a 15 percent reduction in tax rates would increase the portion of an additional dollar of income that a taxpayer keeps. A taxpayer in the 28 percent bracket who now keeps $72 of every additional $100 earned (ignoring state and local levies, if any) would keep $76.20 if his tax rate were cut by 15 percent. A taxpayer in the 15 percent bracket would keep $87.30 vs. $85 under the current system. How significantly a rate cut of this magnitude would affect the incentive to obtain income remains to be seen, but surely it is a step in the right direction increasing the reward to productive activity can be expected to increase production. Critics who doubt the efficacy of tax rate cuts would do well to review the evidence of the 1980s. Federal personal income tax receipts increased nearly 25 percent, in constant dollars, between 1979 and 1989, and the average tax per return increased about 3.2 percent. All of this increase came from high-income returns the average tax due on the bottom 95 percent of returns decreased by about 7 percent, while that on the top 5 percent increased about 20 percent (both comparisons are in constant dollars). In other words, the portion of total personal income taxes due coming from high-income taxpayers actually increased between 1979, when the top Federal tax bracket was 70 percent, and 1989, when the top rate was 28 percent. Contrary to what many people apparently believe, Reagan s tax cuts for the rich served to shift the burden of income taxes toward the rich. The other major provision of the Dole 86 plan, cutting the maximum tax on capital gains in half, would strengthen the incentive to report income in the form of capital gains. For taxpayers in the top tax bracket, capital gains would be taxed at less than half the rate applied to ordinary income. Such a cut could lead to increased investment and encourage entrepreneurial risk-taking. However, it also could divert resources into relatively unproductive investments, i.e., investments that do not necessarily provide a larger before-tax return than other uses of funds, but provide a larger after-tax return because of their preferential tax treatment. Treating capital gains differently from other income also could revive the tax shelter industry that the 1986 tax reform shut down. We have long held that it would be preferable to index capital gains for inflation. Indexing would correct a serious inequity in the current system, whereby investors pay tax on the nominal gain realized from the sale of an asset even though a portion of that nominal gain is the result of price inflation rather than a real gain in income. The politicians, including the Republicans, have shown little enthusiasm for indexing capital gains that have already accrued on assets, however. Most of their proposals would limit indexing to assets acquired or gains accrued in the future. Aside from revenue considerations, it may be that nobody wants to make explicit to taxpayers how much they have lost on fixed dollar claims or how large a portion of their capital gains are illusory and what has happened to the purchasing power of the dollar as a consequence of the politicians mismanagement. Cutting the capital gains tax rate may be politically more appealing, but it is a highly inefficient, even capricious, way to compensate investors for price inflation. The rest of Sen. Dole s tax cut plan and the tax proposals President Clinton reportedly is considering consist mostly of narrowly targeted tax breaks aimed at savers, retirees, students, etc. Some of these proposals might help correct flaws in the current tax system. Others might lead to new tax-induced distortions of economic behavior. In general, reductions in tax rates are preferable to such targeted cuts because they clearly reduce such distortions. However, no amount of changes in the tax code can sufficiently stimulate economic activity to fix the problem of how to pay for the entitlements promised to the next generation of retirees. Sooner or later the programs themselves will have to be scaled back. The sooner this is done, the less disruptive the changes will be, and the better the prospects for keeping taxes and deficits from increasing.

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7 Three of the 12 primary leading indicators new orders for consumer goods and materials, the ratio of manufacturing and trade sales to inventories, and initial claims for unemployment insurance (inverted), reached new highs in our latest appraisal of business cycle conditions (new orders for consumer goods and all other dollar-denominated series are reported in constant dollars). New orders for consumer goods and the ratio of sales to inventories are both appraised as clearly expanding, and initial claims for unemployment is appraised as probably expanding. Some of the steam left the stock market in July. The index of common stock prices failed to reach a new high. However, this 1-month decrease was not enough to indicate that stock prices have stopped cyclically expanding, and the series remains appraised as clearly expanding. The index of housing permits, also down 1 month from its high, remains appraised as clearly expanding as well. There is now some doubt concerning the cyclical status of contracts and orders for plant and equipment. The series was appraised as clearly expanding, but the latest drop in the data was sufficient to change the series appraisal to probably expanding. M2 money supply remains appraised as probably expanding. Up slightly to hours per week, the average workweek in manufacturing remains appraised as probably expanding as well. No trends have emerged from vendor performance or from the change in sensitive materials prices. Vendor performance has increased in recent months but a decrease in the base series in July raises further doubt about the cyclical direction of this series. The base data for sensitive materials prices went into positive territory this month. This is the first time since June 1995 that sensitive materials prices increased. The 6-month moving average of this volatile series, however, remains below zero. M1 money supply and the change in consumer debt, both with established contracting trends, continue to decline, and remain appraised as clearly contracting. Overall, 80 percent (8 out of 10) of the leading indicators with apparent cyclical trends are expanding. Adding to our confidence in the percent of leaders expanding, the cyclical score, AIER s objective BUSINESS-CYCLE CONDITIONS The business outlook appears favorable. The primary leading indicators continue to improve and all six coinciders are at new highs. The Federal Reserve s decision to leave interest rates unchanged should help keep the economy on track for now, but rising labor costs and a tight labor market may put a squeeze on productivity and economic growth. Statistical Indicators of Business-Cycle Changes Change in Base Data Cyclical Status Apr. May Jun. Jul. Primary Leading Indicators Jun. Jul. Aug M1 money supply M2 money supply + +? +? Change in sensitive materials prices??? New orders for consumer goods? Contracts and orders for plant and equipment + + +? Index of new housing permits? Ratio of manufacturing and trade sales to inventories +? Vendor performance??? Index of common stock prices (constant purchasing power) Average workweek in manufacturing +? +? +? Initial claims for unemployment insurance (inverted)?? +? Change in consumer debt? measure of the leading indicators, increased this month as well to 64, from a revised score of 62. The continued improvement of both these series suggests that the near term business outlook is favorable. All six of the primary roughly coincident indicators reached new highs this month. Nonagricultural employment increased by 193,000 new jobs. As has been the trend for the current expansion, the lion s share of these new jobs were in the service sector the manufacturing sector actually lost 20,000 jobs. These figures may be somewhat misleading, however, in that the manufacturing sector hires many temporary employees, whose jobs are tallied in the service sector figure. The rate of increase in the index of industrial production slowed this month, but the series continues to expand. After appearing flat for several months, personal income in manufacturing finally rose above the previous high reached in November 1992 to establish a new high for this business cycle. Manufacturing and trade sales, the ratio of civilian employment to population, and gross domestic product all continue to expand as well. Overall, 100 percent (6 out of 6) of the coincident indicators with apparent cyclical trends are expanding. There were no new highs among the six primary lagging indicators. Now one month off its most recent peak, the ratio of consumer debt to personal income is the only lagger with a clearly expanding trend. Commercial and industrial loans was appraised as clearly expanding last month, but because the series has not yet fully reversed the 2 previous months of decline, the cyclical status of the series was downgraded to probably expanding. The remaining four laggers the average duration of unemployment, manufacturing and trade inventories, the change in labor cost per unit of output in manufacturing, and the composite of short-term interest rates have no identifiable trends. As Chart 1 indicates, this month the Commerce Department released significant revisions to the labor cost series. Previously published data showed that labor costs were decreasing over the past year. In contrast, the revised data indicate that labor costs have been Percentage expanding cyclically Primary Roughly Coincident Indicators Nonagricultural employment Index of industrial production Personal income in manufacturing - -? Manufacturing and trade sales Civilian employment to population ratio +? Gross domestic product (quarterly) Percentage expanding cyclically Primary Lagging Indicators Average duration of unemployment (inverted) +??? Manufacturing and trade inventories +? +?? Commercial and industrial loans + + +? + nc r - Ratio of consumer debt to personal income r - Change in labor cost per unit of output, manufacturing -??? + nc + + Composite of short-term interest rates??? nc No change. r Revised. Percentage expanding cyclically Under Change in Base Data, plus and minus signs indicate increases and decreases from the previous month or quarter and blank spaces indicate data not yet available. Under Cyclical Status, plus and minus signs indicate expansions or contractions of each series as currently appraised; question marks indicate doubtful status when shown with another sign and indeterminate status when standing alone.

8 rising during most of 1995 and Labor costs account for about two-thirds of total business expenses, and are often cited as a leading indicator of price inflation. Our research shows that at best, changes in the labor costs per unit of output coincide with, rather than lead, price inflation. Thus it is far from clear that the newly evident increase in the rate of change in labor cost during the past 12 months is a harbinger of higher price inflation. Overall, 100 percent (2 out of 2) of the lagging indicators with apparent cyclical trends are expanding. However, with only two of the six laggers showing any apparent trend, this percentage could quickly change if any of the other four series that are currently indeterminate establish negative trends. Rethinking the Composite Leading Index This year the Conference Board took over the publishing of the business-cycle indicators previously published by the Commerce Department. The Board also became the new provider of the Commerce Department composite indexes of leading, coincident, and lagging economic indicators. It now is reevaluating the methods used to calculate these indexes and is reconsidering some of the series that comprise the composite leading index. First, it is considering changing the current method used to weight each series in the index. Second, it may drop two of the 11 series that are currently included in the leading index and replace them with one new series. (Nine of these 11 series are used by AIER as leading indicators.) These changes are being considered in part because the Commerce Department s leading index failed to signal the recession and falsely signaled a recession in Beginning in February 1995, the composite leading index declined for 3 consecutive months typically considered a first signal of recession. Some economists also look for at least a 2 percent decline in the series, and in fact it declined by over 2 percent from January Chart 1 Unit Labor Cost, Mfrg.* Revised Old * 2-Mo. MA of 12-Mo. Percent Change Chart 2 Spread Between 1-Year Treasury Note and 10-Year Treasury Bond to November 1995 leaving little doubt that it was signaling a recession. Of course, no recession materialized. The Conference Board blames the current method of weighting the index for the false recession signal in Because of the weighting method, the index of sensitive materials prices, one of the series included in the composite index, receives a disproportionately large weighting. According to the Conference Board, this series alone was almost entirely responsible for the decrease in the leading index. To fix this, the Conference Board is considering giving each series equal weights. Had equal weights been used, the index would not have signaled a recession in This weighting problem is one reason AIER evaluates each statistical series individually, instead of using a composite series. By looking at each series separately we reduce the chance that one series will dominate our analysis. The two series the Conference Board is considering dropping are the percentage change in manufacturers unfilled orders for durable goods and the percentage change in sensitive materials prices. It is considering replacing them with some statistical measure of the yield curve. According to a recent Federal Reserve study, the yield curve might provide useful insight into the future direction of the business cycle. The yield curve is a graphical plot of a smooth curve linking a series of points that represent the yields on bonds of varying maturities. Statistically it can be calculated as the spread, or difference, between short-term and long-term interest rates. The Conference Board is considering using either the spread between the Federal Funds rate and the 10-year Treasury bond or the spread between the 1- year Treasury note and the 10-year Treasury bond. Chart 2 shows the latter. Any point on the chart above zero indicates a situation where short-term rates are higher than long-term rates. With varying lengths of lead time, this yield curve has inverted prior to every recession. However, it is not a perfect indicator. It also inverted in , and no recession followed. The yield spread did not signal a recession in 1995, as the Commerce Department s leading index did. In hindsight, when vision is always 20/20, the yield spread would have added greatly to the performance of their leading index. Although the yield spread is not currently one of AIER s primary leading indicators, we closely watch it as part of our efforts to forecast the direction of the business cycle. There are several good reasons for including the yield curve in an analysis of business-cycle conditions. First, monetary policy greatly influences the yield curve. Also, the yield curve and, in particular, long-term interest rates are influenced by the expectations of market participants, and expectations play an important role in future business activity. Whether or not it becomes a part of the Conference Board s composite leading index, it is still an important indicator of business activity. At the present time, the yield curve tends to support our analysis of the business cycle. For now, the evidence indicates that continued expansion lies ahead. PRICE OF GOLD Aug. 18 Aug. 24 Aug 15 Aug.22 Final fixing in London $ $ $ $ Research Reports (ISSN ) (USPS ) is published twice a month at Great Barrington, Massachusetts by American Institute for Economic Research, a nonprofit, scientific, educational, and charitable organization. Periodical postage paid at Great Barrington, Massachusetts Sustaining memberships: $16 per quarter or $59 per year. POSTMASTER: Send address changes to Research Reports, American Institute for Economic Research, Great Barrington, Massachusetts